What is a CBDC?

There has been a lot of discussion recently about the introduction of Central Bank Digital Currencies (“CBDCs”).

In this blog Gherson’s White-Collar team answers popular questions: what exactly is a CBDC, does any country have a CBDC, and how does a CBDC differ from a cryptocurrency?

Finally, Gherson’s White-Collar Crime team explores how it is in fact through characteristics shared with cryptocurrencies that CBDCs will arguably bring the greatest benefits to financial regulation and compliance (specifically Know Your Customer and Anti-Money Laundering) but alongside concerns over privacy and surveillance.

What is a CBDC?

A CBDC uses an electronic record or digital token to represent the virtual form of the fiat currency of a particular nation. A fiat currency is a centralised government issued currency. Further, whilst a CBDC is a digital representation of a fiat currency, it will be backed by a certain amount of monetary reserves.

Does any country have a CBDC?

The answer is not yet, although China has mentioned a Digital Yuan, Europe a Digital Euro, America a Digital Dollar and most recently the Bank of Russia a prototype Digital Ruble. In fact, China is leading with this initiative and, following trials, it hopes to be the first central bank to issue a CBDC and has produced a set of global rules for CBDCs.

How does a CBDC differ from today’s money?

To help understand the difference between today’s money and a CBDC it is helpful to compare and differentiate under the following characteristics.

One of the key differences, therefore, is that a CBDC is a Digital Currency. As a recent Forbes Advisor article states a “Digital currency is any currency that’s available exclusively in electronic form……Digital currency, however, never takes a physical form. It always remains on a computer network and is exchanged via digital means”. As such, a CBDC is always electronic (i.e. cannot be converted to physical money (i.e. cash)).

Further, a CBDC would enable an individual to hold an account with the Bank of England, as the BoE states: “The Bank provides physical money in the form of banknotes, which can be used by households and business to make payments. We also provide electronic money, but this can only be used by banks and selected financial institutions.

A Central Bank Digital Currency would make electronic money, issued by the Bank of England, available to all households and businesses. This would allow everyone to make electronic payments in central bank money”.

How does a CBDC differ from a Cryptocurrency?

Whilst all CBDCs are Digital Currencies, not all Digital Currencies are CBDCs. Another type of Digital Currency (i.e. cannot be converted to physical cash) is a cryptocurrency. However, although both are Digital Currencies, there are some fundamental differences if one again compares and differentiates under the following characteristics:

CBDC Issuance

The clue here is in the name. A CBDC is issued by a Central Bank, therefore CBDC’s are issued centrally. As Alberto Muñoz Cabanes, Professor at the Department of Applied Economics and Statistics at the National Distance Education University (UNED) explains: “One of the differences between a digital euro and a Bitcoin is the way they are issued. While the operations, in the case of the euro, are centralized and the only one that can issue it is the ECB, in the case of a Bitcoin it is totally different”. In contrast, new Bitcoins are “mined” by miners (who essentially solve complex mathematical problems) and the issuance is governed by computer code. Therefore a CDBC has centralised issuance, whereas a cryptocurrency’s issuance is decentralised.

CBDC Centralisation

CBDC would therefore be more centralised than a cryptocurrency. Not least in relation to issuance but also, for example, in relation to record keeping as the Central Bank could centrally record and verify all CBDC transactions. With a cryptocurrency, on the other hand, a record of transactions is generally shared across the whole network and transaction verification is done cryptographically by miners (i.e. there is no need for a central intermediary). If a CBDC relies on blockchain (i.e. distributed ledger) technology (“DLT”) then depending on the permissions, it could be more decentralised. The precise design of CBDC, and the extent to which they rely on DLT, and are decentralised, is still undetermined and is a very interesting area to follow.

CBDC Reserves

Unlike with a CBDC, there are no reserves to back up the valuations of cryptocurrencies.

Implications – financial regulation and compliance vs privacy and surveillance

The introduction of CBDCs therefore has huge implications, not least in that it will ultimately lead to the death of physical money (i.e. cash).[1]

In addition, the fact that a Digital Currency cannot be taken off network (i.e. converted into physical form),[2] would enable governments and regulators to track it better, as this would reduce the potential for anonymity. Further, given that a CBDC could be reliant on DLT, this could bring additional transparency brought by decentralisation. Indeed, as far back as 2016 the FCA noted how DLT generally could potentially assist with KYC and AML. Therefore it is through being a Digital Currency, and potentially reliant on DLT, that CBDCs would bring benefits to regulation and compliance through transparency transaction reporting, monitoring and tax recording (a few examples out of many).  Combined on a global scale, this would assist the global fight against money laundering.

However, any exclusively electronic and shared system would raise potential privacy concerns.  Increased transaction monitoring would give governments and regulators further transactional oversight. Sharing information on a global basis could bring about GDPR and privacy concerns.

Conclusion

CBDCs share characteristics with both today’s money and cryptocurrencies. However, it is the characteristics that they share with cryptocurrencies (i.e. a Digital Currency and decentralisation) that arguably bring the biggest benefits to financial regulation and compliance but also the most concerns.  CBDCs could therefore herald, through increased transparency, a new era of improved compliance but at a price of increased surveillance. This is without doubt an extremely exciting area to watch going forward.

If you have any questions about CBDCs, cryptocurrencies or the general regulation of blockchain technologies, Gherson is able to provide expert advice.

The information in this blog is for general information purposes only and does not purport to be comprehensive or to provide legal advice. Whilst every effort is made to ensure the information and law is current as of the date of publication it should be stressed that, due to the passage of time, this does not necessarily reflect the present legal position. Gherson accepts no responsibility for loss which may arise from accessing or reliance on information contained in this blog. For formal advice on the current law please don’t hesitate to contact Gherson. Legal advice is only provided pursuant to a written agreement, identified as such, and signed by the client and by or on behalf of Gherson.

©Gherson 2021